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Bet on a 2009 Housing Recovery

Does housing have to stabilize before stocks will recover?

The housing bubble was caused by poor lending standards, lax regulation, and low interest rates. Poor lending standards have met a natural death, lax regulation is irrelevant now -- it turns out banks do self-regulate when lower executive bonuses are suddenly on the table -- but today's low interest rates should surely impact housing prices.

But is it enough to save the housing market? And what does it mean to your stock portfolio?

Avoiding foreclosuresAlmost half of home sales these days are distressed sales, so reducing foreclosures is the first step to stabilizing the housing market. Low interest rates can help achieve this goal. Homeowners with adjustable rate mortgages (ARMs) will build more equity, since more of their mortgage payment will go toward paying back the principal. Plus, lower rates allow monthly payments to be reduced if necessary, keeping people in their homes.

Unfortunately, "option ARMs" -- loans where the homeowner had the option of interest-only or even less-than-interest payments for a period of time -- are still a problem. Though these mortgages often had low teaser rates, about 70% of option ARM holders made the minimum payments. So, even with the low interest rates, the combination of the teaser rates expiring and normal amortizations starting could cause payments to jump close to 100% in some cases.

About $500 to $600 billion in option ARMs will reset over the next few years. With that payment shock many -- maybe over half -- will default, hurting the market.

Of course, supply is only half the equation. Low interest rates and lower housing prices should increase demand by improving housing affordability. Despite the option ARM issue, improved affordability will likely cause housing prices to begin to stabilize some time in 2009.

Necessary or not? Regardless, is a housing recovery necessary before the economy can recover?

Certainly it would help. About seven million people are directly employed in construction. A recovery would boost homebuilders like Pulte(NYSE:PHM), and materials providers like Cemex(NYSE:CX) and Weyerhaeuser(NYSE:WY). Not to mention the banking industry.

What's more, this decade, consumer spending has been driven by homeowners withdrawing equity from their homes. In 2005 and 2006, mortgage equity withdrawals were $150-$200 billion each quarter, or about 5% of GDP in total. These days, people are paying off their mortgages.

These equity withdrawals historically stimulated the economy. But, they were already absent through most of 2008, so consumer spending and the stock market should already reflect these conditions.

A penny savedBesides, low interest rates provide their own stimulus. Consider how much money consumers are saving because of the declining interest rates. In the second quarter, there were about $2.35 trillion ARMs and $11.3 trillion of fixed-rate mortgages outstanding. Since 2006, the benchmark interest rate to which many ARMs are pegged has fallen about four percentage points, leading to a savings of $94 billion annually on ARMs alone.

But, mortgages applications recently hit five-year highs due to a huge surge in refinancings. If only 20% of the fixed rate mortgages refinance, it would save another $90 billion. Combined, the total annual savings would be $184 billion.

To put that number in perspective, the U.S. GDP is about $14.4 trillion. So, consumers have an amount equivalent to 1.2% of GDP to spend. That's more than the $152 billion stimulus package of the second quarter, which helped boost GDP by a surprising 2.8% annualized rate in that quarter.

Admittedly, it is much less than the $700 billion TARP bailout or the House's proposed $825 billion stimulus package. But, that's because those plans are huge. Combined, they're equivalent to every worker in America donating the results of their labor in January and part of February toward bailing out the country.

Portfolio resuscitationOverall, many of the direct effects of the weak housing market have been felt throughout 2008. Much of the stimulus, however, is still to come. So, though a housing recovery would help the economy recover, it might not even be necessary.

What's more, stocks have dropped significantly since their 2007 highs, and they were not particularly expensive even then. Even with earnings estimates reflecting the terrible economy, many companies seem cheap.

For instance, Adobe(NASDAQ:ADBE) owns Flash and Acrobat, software that's on almost every computer, as well as Photoshop and Dreamweaver. Despite its best efforts, Microsoft(NASDAQ:MSFT) hasn't really been able to make any inroads against the company, which shows just how entrenched Adobe is. The company looks cheap with a couple billion dollars of cash and an earnings multiple below 14.

Or consider FedEx(NYSE:FDX) and UPS(NYSE:UPS). They're both down as shipping volume falters in the slowing economy. Yet over the long term, these companies are likely to gain as weaker competitors fail. They too look cheap at mid-teens earnings multiples.

The Foolish bottom lineIf stocks are priced attractively when their earnings are near cyclical lows, what will happen when the economy recovers? A potent combination of escalating earnings and low valuations could result in excellent returns for investors over a number of years.

You still need to be cautious -- the economy hasn't turned around yet, and more companies could fail. But now is the time to look for bargains. Our Inside Value team is doing just that and we've found the stocks that we believe will both survive this rough patch, and outperform during the recovery. You can read all about them with a 30-day free trial.

Fool contributor Richard Gibbons doesn't find his arms as optional as other folks seem to. He owns shares of Microsoft, which is a Motley Fool Inside Value pick. FedEx and Cemex are Stock Advisor recommendations. Cemex is also a Global Gains selection and Fool holding. UPS is an Income Investor selection. The Fool's disclosure policy just refinanced the server it lives in.